Investment option in a expanding interest rate system
This announcement will send some cheer to investors of Fixed income securities like Fixed Deposit (FD). In the recent months only, FDs have been giving 9-10% income. Now, this rate hike would mean further increase in the interest rates that FDs offer. It may take some time for that to be transmitted through the banking system.
The rate hike for repo and reverse repo of 50 basis points ( 100 basis points is 1% ) was received by the market with a bit of shock, as they were hoping for a 25 basis points hike.
Coming to those with loans, it could be difficult times ahead. The loans, most of which are floating rate loans these days, will all move up by 0.5% and will put pressure on the borrowers. The bad news is that the rate hikes are not over yet, if one were to look at the inflation situation in the country, commodity prices across the globe and crude oil prices in particular (which has linkages across all sectors of the economy).
Now coming to debt funds, these are times when investors have to be careful as to what they pick up for investment. Investors would know the inverse relationship the interest rates have with the fund performance (NAV). This can be explained with an example. Let’s say A has invested in a Rs.100 bond, yielding 8%. Now, if the interest rates move up, new bonds get issued at a higher coupon rate, say 9%. The old bond which is yielding 8% will become less valuable. If it has to compete for customer, the old bond will have to sell for less such that the yield to a person who buys is now 9%. Hence, anyone holding securities which are traded in a rising interest rate scenario will see an erosion of wealth. If a debt fund is holding such securities, there will be a fall in NAV as the prices of the underlying securities will fall. But again the effect on different kinds of debt funds would be different.
Investors who have a long-term horizon and who are investing in income and Gilt funds can stay out – but give a time frame of 2 years plus, for their investment. This is because; the rate cycle is expected to reverse direction in a matter of months. If that were to come to pass and the interest rates come down over time, the NAV of these funds will rise. But for that to happen, one has to wait. That is precisely why I had mentioned that one should invest in funds investing in medium to long-term instruments, with a view of over 2 years.
Shorter duration funds like Ultra short term funds are less affected than the longer tenure funds, whose sensitivity is more. Investors who do not want to be exposed to the interest rate risk (i.e the risk of their yields rising or falling due to the interest rate movement of the underlying securities in view of the fact that these securities are traded) should look at Fixed Maturity Plans (FMPs). In FMPs the underlying investments are subject to fluctuations. However, it does not affect the final performance as the securities are held to maturity, when the coupon rate becomes payable. Also, FMPs can buy securities which mature on or before their maturity date. This makes FMPs a least risk option when the interest rates fluctuate. Since the interest rates have gone up, more instruments with higher yields will become available in the near future, prompting more FMPs to be launched.
The other option before an investor is a dynamically managed debt fund, where the fund manager takes a call on the unfolding situation and manages the portfolio. These funds can again give good returns based on the expertise of the fund manager.
Source: [money control]
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